Economic Theories of Growth and

Development; Historical Concept

Lecture 2

Prof. Dr. Durmuş Özdemir Department of Economics

Yaşar University

• Basically, Develoment means İmproving the conditions of life.

• Basically, Economics is knowledge about the effective use of resources in producing the material basis of life.

• Development fundamentally an economic process.

• Economics has an abiding interest in development, and all theories of development have significant economic dimensions

Development as an economic

process

Development issues under

historical economic thought:• Pre-classical

– Medieval Christianity

– Merchantilism

– Thomas Hobbs

– John Locke

– David Hume

• Classical– A. Smith

– Physiocratic system

– Bentham

– Ricardo

• Marginalist

• Keynesian

• Post-Keynesian

• Neoliberalism

• IMF, World Bank Policy

Pre-classical beginnings

• Medieval christianity: Medieval thinkers found God active in all world processes. Medieval theorists always combined religion with economy; indeed, economics was thought through the medium of religion.

• Medieval (catholic) christianity emphasized duty to God rather than the rights of the individual; this duty entailed moral limitations on the economic actor.

• PRICE: Further more, according to the medieval doctrin of ‘just price’ every commodity had a true, absolute value. True value was determined by common estimation of the cost of production, which usually meant the amount of labour contained in a product.

The medieval doctrin of ‘just price’

• There was concerns also that the price set by the market for a commodity should be just and equitable, a concern that went back to the Greek philosopher Aristotle, if not the earlier thinkers.

• Leading thinkers of medieval period, Albert Magnus (c.1200-1280) and Thomas Aquinas (1225-1274) said; price were matters of justice and the law had a duty to fix them and punish individuals who exceeded the just price.

‘just price’ (Cont.)

• The belief that communal economic justice

reflected God’s will began to erode with;

– Urbanization

– Monetization

– Secularization

– Protestant reformation

With the onset of modernity, with its central

belief that humans create their own destiny.

Pre-Classical...

• In the case of attitudes toward work, classical antiquity had associated wage labour with slavery, while Augustinian Christianity defined work as punishment for Adam’s disobedience of God.

• But in the notion began to emerge of labour as the virtuous source of wealth.

• The most radical version of this new idea is associated with the sixteenth century Protestants. They wanted to glorify God not through prayer alone but more actively, by working hard, even at ordinary tasks.

Protestants....

• In protestanism, the idea was that God worked

his will through secondary means, principally the

labours of individual men and women, rather

than directly through miracles.

• According to Martin Luther (1483-1546), God

might grant gifts to humans, but people had to

lend a hand by working- people had to give God

a mask behind which he could act.

Calvinism

• For John Calvin (1509-1564), the notion of pre destination, the idea that entry to heaven had already been decided for each person, paradoxically meant that indivuduals were responsible for their own behaviour.

• Calvinism was elaborated, by a serious of puritan theologians between 1580-1640, as an ethical code for the conduct of daily life, and as a set of institutions necessary for compelling obedience among the faithful.

• i.e. They described shoddy crftsmanship as dishonoring God..

Calvinism and Classics...

• Human acquisitiveness changed from being a sin in medieval catholicism to being a service to the community under early modern protestanism.

• In Calvinism.. Going to heaven was reinforced by an ethic of self discipline.

• Classical economics derived from the new, protestant attitudes toward labour, wealth, and productive life.

• Classical economics developed also in a conflict ual relation with mercantilism.

Merchantilism...

• Merchantilism (lasting from 15th to early 19th century) was a total system of ideas, politics, institutions, and economic practices.

• Merchantilist political policy aimed at increasing national power, symbolized by the political might of the state..

• National power rested on economic means (rather than the breavery of country citizens or spirit of its people)

• Production was understood in the modern way as the application of labour to natural resources.

Merchantilism...(Cont.)

• Harsh methods were used to extract hard work. (use of criminal slavery etc.)

• Colonies were desired to enrich the mother country by providing raw materials for its businesses and markets for its manifacturers.

• Under merchantilism, the European states granted trading monopolies over great streches of the world’s surface to joint stock companies.

• Merchantilism broke with medieval precedent(Example). It was an amoral system, in terms of ends and means, in which the political welfare of the state replaced the spiritual welfare of the individual.

Merchantilism...(Cont.)

• In general, merchantilist economists thought that states should foster development (defined as increased national production) through internal improvements (e.g. Transportation), by the promotion of national industries (especially manufacturing and through regulations-internal and external).

• On the whole, people were taken as they were, by now, presumed to be (persuing their own self-interest) but were guided by state policy in directions that would enhance the well-being of the state.

• Merchantilism was rationalist rather than mystical, believing in the application of science to the solution of practical problems.

Merchantilism...(Cont.)

• During 17th century, particularly protestant merchantile and manufacturing circles, much more definite ideas about a free market economy within, yet partly opposed to, the merchantilist system.

• The idea of free markets was based on a number of principles: potential harmony between individual self-interest and the public interest without state intervention: the equilibrating tendencies of the forces of supply and demand in free markets: the achievement of higher productivity through specialization and the division of labour: and, most importantly, the ability of the market to yield natural or even just prices.

Economic freedom

• A number of writers at the end of the

seventeeth century proclaimed the

benefits of economic freedom. Example:

Pierre Nicole (1625-1695)

• P.Nicole thought that human ruthlessness

could be directed by free markets into

beneficient channels.

Political philosophers of 17th, 18th

century

• Thomas Hobbs; State of nature, commodious living i.e. Comfort and happynes.

• John Locke; property rights extended.

• David Hume; Introduced experimental methods, study of morality. All humans were consuming passion but socialization is in peoples interest.

• They are important in forming the philosophical basis of classical economic theory: in many ways the three form steps along the path from merchantilism to modern capitalism.

Political philosophers......

• Hume favoured the middle class as the best and firmest basisi of public liberty supported free trade against merchantilist restrictions, yet found a need still for government intervention to preserve national economic advantage.

• In general, the philosophers and political economists of 17th and 18th century Britain theorized on behalf of a new class of merchants and manufacturing entrepreneurs than coming to the fore, and increasingly argued against the entrenched power of the landowning nobility and the state.

Classical Economics

• Start with Adam Smith’s ‘The wealth of Nations’(1776) followed by John Stuart Mill’s ‘ Principle of Political Economy’ (1848)

• During this time economists was part of a broader system of political economy embedded in a even more general moral philosophy.

• Classical economics asked questions not only about the causes of the growth of wealth, but about the social results of development, particularly its effects on the ‘lowest order of society.

• Classical economists derived, in an immediate, technical sense, from notions developed by the physiocrats, member of a school of eighteen century French Enlightenment thought lying midway between the medieval and the modern.

Physiocratic system

• Laws of human behaviour deriving from the wills of God could be discovered by theorist and followed by everyone.

• The physiocrats thought that God had endowed nature with the capacity to produce wealth, and that God’s will was realized through the medium of agricultural labour.

• Agriculturally derived surplus circulated through the entire society, but was drained off by people engaged in ‘nonproductive’ economic activities, such as commerce and manufacturing.

• This french theory of the natural (but God-driven) origin of value might be compared with British theories developed at the same time which evidence a greater seperation of labour and value from both nature and God. The difference explained by A. Smith (1723-1790).

Classical..... (Cont.)

• In A. Smiths ‘Theory of Moral Sentiments’ published in 1759; Smith tried to reconcile the conflict between the pursuit of material gain and the maintanence of public morality by discovering the scientific laws covering both.

• Smith and Hume opposed the traditional Greco-christian doctrin that a commitment to spiritual life excluded the pursuit of material advantage.

• More sceptical Hume thought that all value judgements were merely ‘a species of sensatin’ that morality was relative to the sentiments of each person and, indeed could be accounted for by the principle of self-love.

Classical..... (Cont.)

• While deeply influenced by Hume’s commercial humanism, Smith believed that there were laws both of external nature and of inner human morality that were divine.

• Even good people were frequently corrupt by selfish passion.

• Thus Smith came to believe in a stoic harmony between the higher and lower motives, between virtue and self-love.

• So, Smith argued that a new, imperial science of morals could be developed that would restrain self-love with in socially beneficial limits derived from the impartial spectator’s judgement. i.e. Property rights were justified in the eyes of the impartial spectator when based on the individual’s labour.

Self-love with in socially beneficial

limits• The individual should preveil on the other’s self-

love, appealing to the othe’s own advantage to get the other to do what he or she require: ‘Give me that which I want, and you shall have this which you want’.

• In direct contrast to the christian disavomal of egotism, Smith wanted to use human selfishness as an economic drive.

• But he thought that self love should be both self-regulated and externally limited by laws. Indeed Smith himself prefered self interest as guide to economic behaviour.

Self-love with in socially beneficial

limits• Rather than pure selfishness, he said, justice

should be basis of society.

• Economic growth, for Smith, depended on capital accumulation, which in turn depended on saving and the virtues of fragality and self-command.

• Economic growth also supposed a cultural rooted in morality, a system of natural liberty with respect for the higher virtues.

• Smith’s system of natural liberty means, there should be no artificial impediment to trade.

A. Smith’s key points in his

thoughts;• 1)Prosperity and wealth linked with more trade.

• 2)Specializing various tasks involved in production cause; – Time saving

– Better production..productivity increase.

• 3)Market is a driving force for invention, innovation, and risk taking.

• 4)Reform of education and religion

• 5) Trade leads efficient allocation of resources, but thought too that a just political economy would also encourage high wages; Any producer motivated only by greed who charged too much for a product, or paid too little for labour, would find himself without buyers or workers. Ower the long run, marketsand free competition would force prices toward their natural, or socially just, level. Self regulating markets were the ‘invisible hand’ that transformed private interest into public virtue. For Smith, markets were virtuous institutions of social efficiency.

A. Smith’s key points in his

thoughts (Cont.)

• 6) Smith (as medieval argument) natural prices of commodities derived from their real costs. The difference between the natural prices and market prices can be translated in moral terms.

• 7) Utility can not determine its price rather the value of a commodity owned by someone intending to exchange it for other commodities was equal to the quantity of labour the community could purchase or command. LABOUR is the real measure of the exchangable value of all commodities.

A. Smith’s key points... Cont.

• Capital originates in saving from current

revenue and was used to hire workers

who produced value, putting in motion an

additional quantitty of industry which

added to the annual product of a country.

• PROFIT must be given to risk taker (like

owning a land ::: Rent.

A. Smith.. Price• Thus Price (exchangable value of a commodity resolved into:

– A) Wages

– B) Profit

– C) Rent

• ‘Natural prices’ determined in this way, were brought into equality with market prices by competition.

• If market prices extended natural prices land-lords and capitalists would shift land and capital into profitable employment with the reverse happening, when market prices dropped below natural prices – hence productivity efficiency and justice. While the accumulation of capital and its employment in mechanized production might eventually be stalled by scarcity of workers and high wages, Smith thought that population too responded to market incentives, More children were born when wages were high so that growth could continue indefinitely withouth labour shortages.

• Hence, an automatic mechanism produced productivity and growth without state interference.

Godwin and Malthus

• William Godwin (1793) in ‘Enquiry concerning the principles of Political Justice’ argued that Human life indefinitely extendable.

• Thomas Malthus (1766-1834) ‘Essay on Population’ responded negatively. Human passion (meant sex). Population increase more than food supplies.

• Thus, while population increase geometrically (2,4, 8, 16, ..) the food production increase arithmetically ( 2, 4, 6, 8,.. ) .. Food shortages..

Jeremy Bentham (1748-1832)

• In ‘ ıntroduction to the principles of morals an Legislation’ (1780).

• Nature had placed humans under the governance of two sovereign ‘masters’;– A) Pleasure (which made all people happy)

– B) Pain (everyone hated)

• Acording to Bentham, The amounts of each could be measured... ‘Principle of utility’

• Judged every human action by its effect on augmenting or diminishing the happyness of the individual in question.

Bentham and Utilitarianizm

• When the laws of utility were countered by reason, the reason themselves were based in the same principle of utility.

• For Bentham, the community, furthermore was a fictitious body, and the public interest merely the sum of private interest.

• Bentham’s system called ‘utilitarianism’.

• Utilitarianism entered economics mainly through the ideas of the ‘philosophical radicals’ one member of this group was a British millionaire David Ricardo (1772-1823) . İn ‘principle of Political economy and taxation’.

Ricardian Theory of Growth and

Income Distribution• Ricardo accepted Smith’s labour theory of commodity

value with some modifications.

• 1) Commodity value was also determined by scarcity.

• 2) Benthamite elaborations:– A) Labour was the universal measure of value because it always

involved exertion and was a pain, whereas consuming labours products was always pleasurable.

– B) But placed greater emphasis on the distribution of value, especially the part going to rents (the proportion paid to landlords)

• Ricardo .. Suspicious.. Markets might not yield just price given the entirely different kinds of labour in vested in products and the different combinations of labour with capital invested in different kinds of production.

Ricardo ... Cont.

• Ricardo (like Smith) saw the economic world tending to expand, with capitalist accumulating, building factories, employing more workers, and increasing wages.

• Ricardo then added a further pessimistic dimention to the theory of economic growth . He argued that with an expansion of population and an increased demand for food, the margins of aggricultural production would expand bringing into cultivation land of lesser fertility, thereby increasing the cost of grain (food), yet increasing the returns to land lords owning the better lands, earning them differential rents. In turn, the capitalist would be faced by higher wage costs necessary to sustain workers, while the main class benefitting from economic growth was the landlords even though, the radical Ricardo concluded, they contribute little to the wealth-creating processes.

Ricardo ... Cont.

• Ricardo (like Smith) was against the land owning class.

• In the early 19th century British landlords were protected from foreign competition by a system of Corn law; (ımposing import duties on grains depending on foreign price) ensuring that land owners benefitted from the ındustrial revolution more or less in the way Ricardo theorised, except that location near markets assumed greater significance than fertility as the source of differential rents.

• Ricardo (like other British radicals) opposed the corn laws, with the famous ‘Trade Theory’ based on comparative advantage.

Ricardo ... Cont.

• Human happyness, (Ricardo said) would be increased by each country producing (and than trading) those commodities that it was best fitted to produce by virtue of natural or historical circumstances.

• Even when one country was consistently more productive than another, trade would benefit both.

• True: Each country specializing in comparatively advatageus product (or least comparative disadvantage) with production being prevented from concentrating exclusively in one country by the difficulties of moving capital accross national boundaries.

• Ricardo worked with James Mill (Radical Philosopher and the father of John Stuart Mill (1806-1873))

John Stuart Mill (1806-1873

• Wrote ‘Principles of Political Economy’.

• Principles of competition were bases economic laws that could be outlined with precision and given universal validity by an abstract science.

• For Mill, the economic law of diminishing returns, in which additions to the labour working agricultural land were not met by equal additions to product, restricting productivity and growth, could in part be transcendend in manufacturing, where productivity could be increased almost without limit.

• Mill argued... Malthus’s pessimistic principle of population could be avoided by workers voluntarily restricting their numbers.

Mill... Cont.

• Mill believed that there was no change of general over production (and thus long term depressions), although specific commodities might temporarily come into oversupply (so there could be short term economic fluctuations). Here again we see the liberal ideal of unlimitted progress.

• The most important contribution of Mill; Differentiating science from values, that is, while the scientific laws of economics applied to production with the character of physical truths the distribution of wealth was a different matter entirely, being a question more of human institutions, as with laws and customs.

• Once things had been made, people could do with them as they pleased, society could redistribute wealth through state intervention.

Mill... Cont.• Mill found the notion of the struggle for existence as an ideal

of economic life to be merely a disagreable symptom of one (early) phase of industrial progress.

• Mill viewed the relations between workers and capitalists as an association of mutual suspicion, but thought that this antoganism could be relieved by profit sharing, and eventually avoided altogether through parnership and workers ownership of factories.

• Mill thought that laissez-faire (the practice of nongovernmental intervention in the economy) should be the general rule, but allowed many exceptions, as with poor relief and factory legislation.

• Mill was a radical liberal who believed that capitalism would eventually give way to cooperativism.

• More extreme versions of these ideas, were worked out by Marx and Engels, in many ways the final (critical) memvers of the classical school of political economy.

Fredrich List (1789-1846)

• An alternative economic perspective in the classical tradition.

• List agreed with the principle of free trade proposed by the classical economists. But he thought that free trade presupposed a condition of eternal peace and single set of laws for a world that had yet to come into existence.

• He argued that under the actually existing conditions, in which Britain dominated the world’s manufacturing industry, free trade would bring not a ‘universal republic of equal countries, but ‘universal subjection of the less advanced nations to the supremacy of the predominant manufacturing commercial and naval power.

List... (Cont.)

• List further argued that universal republic of

national powers recognizing each other’s rights,

and a situation in which free trade could confer

the same advantages to all participants, could

only come about when a large number of

nationalities had reached the same level of

development.

• List, meantime, was for the protection of national

economies untill they could compete on equal

terms.

The Neoclassical Interlude

• In the last third of the 19th century

economics changed from ‘political

economy, part of a moral philosophy

critically involved with social issues’ to

• A specialized scientific discipline

fascinated by calculus, algebra, and

increasingly removed from social

concerns.

Change in study of economics

• The central theme of economics changed from

growth of the national wealth to the role of the

margin in the efficient allocation of resources,

marginal utility, neoclassical economics’ leading

concept, was anticipated by a little known,

Hermann Heinrich Gossen, in a book first

published in 1854.

• Gossen advocated an economics that was

utilitarian, mathematical, and centered on

consumption rather than production.

Gossen... Cont.

• For Gossen (as for Bentham), the aim of human conduct was to maximize enjoyment.

• There were laws of pleasure: satisfaction decreased as any activity proceeded until satiety proceeded.

• To obtain the maximum total enjoyment the individual with limited resources, chose among a mixture of activities, discontinuing each when the amount of pleasure if gave equated that of all other activities. This last ounce of Benthamite pleasure became the famous economic principle of marginal utility.

Jevons, Menger and Walras

• They, independently, simultaneously developed the idea of marginal utility, inherent in Gossen.

• Jevons, W.S. (1835-1882); benthamite and mathematician economist

• Carl Menger (1840-1921); Economics had no ethical or philosophical implications.

• Leon Walras (1837-1910) Concept of equilibrium

Jevons

• Calculus of pleasure and pain, and mathematics was its methods for economic science dealth in quantities rather than qualities.

• The notion that value was created by labour was built a minor variation on a major theme that value depended instead on utility. That is utility was the quality of an object that induced pleasure or prevented pain, depended on the inclination of person.

• Not the total utility given by consuming all of a commodity, but the final degree of utility induced by a very small increment in consumption.

Carl Menger

• Goods had utility because they satisfy

needs directly (bread) or indirectly (i.e.

Flour)

• Maximal wants with the available scarce

means. (Jevons or menger did not actualy

used the term ‘marginal utility’)

Walras

• With individuals possesing stocks of goods that they exchanged in competitive markets until equilibrium was reached and price was such that demand and supply were equal.

• Special contribution: generalizing from the exchange of one commodity to the exchange of all, including factors of production (land, labour, and capital). He called ‘general exchange equilibrium’

• Competitive markets maximize total utility.

• Walras personally favoured state intervention, compulsory education, restrictions on working hours, monopoly control etc.

Alfred Marshall (1842-1924)

• Wrote: ‘Principles of Economics’

• Representative firm model with 3 time periods:

– 1) market (supply fixed- demand determined).

– 2) Short run (Forces of supply had a larger role)

– 3) Long run (supply more important factor)

• Increasing returns to scale of production, that

firms reaped internal and external economies,

and that capitalism could raise the standard of

living for ordinary people.

Vilfredo Pareto (1848-1923)

• Set out the mathematical conditions of

Walras’s general equilibrium in the

achievement of an optimal economy

(‘pareto optimality’)

J. B. Clark (1847-1938)• Justified the distribution of income under static conditions as

according with the rights of property.

• According to marginal productivity, everyone got what he or she deserved, wages were the whole product of labour, interest was the product of capital, profits were the product of the coordinating actor.

• Altogether, neoclassical economic theory asserted that, under conditions of perfect competition, price making markets yielded a long run set of prices that balanced, or equilibrated, the supplies and demands for each commodity in production and consumption. Given certain conditions, such as the preferences of consumers, productive techniques, and the mobility of productive factors, market forces of supply and demand allocated resources efficiently, in the sence of minimizing costs, and maximizing consumer utility, in the long run. Participants receive what they deserve. Capitalism best of all possible world.

First critique

• Thorsten Veblen (1857-1929); Pursuit of gain often caused unemployment, higher prices, higher costs and delayed innovation.

• Big firms svallow small businesses. Rather than class conflict (in Marx) He ephasized conflict between 3 cultural tendencies.– The machine process

– Business enterprise (eventual fail)

– War like or predatory beliefs.

• Future system would either involve domination by engines or reversion to archaic absolution under military domination (Germany + Japan were his examples)

Dynamic Analysis

• A front runner name: Joseph Schumpeter (1883-1950): Neoclassical economics, which took basic social variables as given and thought that the play of self-interest in competitive markets would bring resource allocation in to equilibrium, was static analysis.

• His own model saw innumerable exchanges constituting, in their totality, a circular flow of economic life.

• Dynamic developments of economic systems.

• The change in all parameters and equilibrium

Keynesian Growth Theory

• J.B. Say, in British neoclassical economics most theorists followed.

• Say’s reasoning that general over production or unemployment were impossible: production meant hiring labour and purchasing machines and materials, which generated incomes, and increased demand so that ‘ supply creates its own demand’ But part of income is saved. So... Saving stops the upward growth.

• Keynes criticisized..

Keynesian System...

• Real Investment (in new factories, tools,

machines, and greater inventories of

goods) was the crucial variable.

• I (r), S = I, Thus when S goes up I goes up

too. Keynesian Harrod Domar model of

growth summarize the Keynesian system

of growth.

Harrod-Domar Model• Let Y represent output, which equals income, and let K equal

the capital stock. S is total saving, s is the savings rate, and I is investment. δ stands for the rate of depreciation of the capital stock. The Harrod-Domar model makes the following a prioriassumptions:

• 1: Output is a function of capital stock

• 2: The marginal product of capital is constant; the production function exhibits constant returns to scale. This implies capital's marginal and average products are equal.

• 3: Capital is necessary for output.

• 4: The product of the savings rate and output equals saving, which equals investment

• 5: The change in the capital stock equals investment less the depreciation of the capital stock

•

Derivation of output growth rate is

as follows (H-D Growth model)

• with dots (for example, ) denoting percentage growth rates.

• First, assumptions (1)-(3) imply that output and capital are linearly related (for readers with an economics background, this proportionality implies an capital-elasticity of output equal to unity). These assumptions thus generate equal growth rates between the two variables. That is,

H-D Growth model (Cont.)

• Since the marginal product of capital, c, is

a constant, we have

Next, with assumptions (4) and (5), we can find capital's growth rate as,

H-D Growth model (Cont.)

• In summation, the savings rate times the

marginal product of capital minus the

depreciation rate equals the output growth rate.

• Increasing the savings rate, increasing the

marginal product of capital, or decreasing the

depreciation rate will increase the growth rate of

output; these are the means to achieve growth in

the Harrod-Domar model.

Development Economics

• After the WW II, most western governments committed themselves to Keynesian full employment as a policy objective.

• There was widespread feeling that Keynesian principles of macroeconomic management of the economy by governments should be extended to developing countries;– Decolonization

– The cold war

– Competition

Truman (1949) US committed to democratic fair deal for entire world

Conclusion

• Questions

• Discussions